More bookblogging

I’m starting now on what will I think be the hardest and most controversial chapter of my book – the argument that the search for a macroeconomic theory founded on (roughly) neoclassical micro, which has been the main direction of macro research for 40 years or so, was a wrong turning, forcing us to retrace our steps and look for another route. As always, comments and criticisms accepted with gratitude.

We are now all Friedmanites, Lawrence Summers, (former US Treasury Secretary, now Director of the White House’s National Economic Council, and prominent New Keynesian economist) and

At the end of the 19th century, British Liberal politician Sir William Harcourt observed “we are all socialists now”. Harcourt was referring to a radical land reform measure that had been denounced as socialist when it was introduced, but was generally accepted by the time he was speaking (a couple of years later). Harcourt’s point was applicable to the whole trend of economic and social policy, in Britain and elsewhere, from the 1867 Reform Bill that gave millions of working class men the vote (women had to wait until after World War I) to the crisis of the 1970s.From progressive income taxes to publicly-owned infrastructure services (both prominent items in the 10-point program of the Communist Manifesto)) ideas that were unthinkable in mainstream politics became issues of political contention and then established institutions.

As a pithy summary of the way ideas that were once radical become acceptable, and are ultimately embodied in conventional wisdom, Harcourt’s quip has never been bettered. As a result, it has been reused many times over.

One of the most notable adaptations of Harcourt was that of Time Magazine in 1965, which noted, following the successful use of fiscal policy to stabilize the economy that “we are all Keynesians” now. This statement was made by Keynes’ greatest modern critic, Milton Friedman (though he later said it had been taken out of context). Even more famously, it was repeated by Richard Nixon in 1971.

But whereas Harcourt was speaking at the beginning of a nearly a century of reform that did indeed take economic policy in a socialist, or at least social-democratic direction, Nixon’s statement marked the end of the era of Keynesian dominance.

In fact, Nixon was citing Keynes’ aversion to the gold standard (a “barbarous relic”) as a justification for abandoning the pegging of the US dollar to gold, which was a central feature of the Bretton Woods system of fixed exchange rates that had underpinned Keynesian economic management since World War II. The outcome was not a system of stable exchange rates backed by a basket of commodities rather than gold, as Keynes had proposed, but the complete breakdown of Bretton Woods and a shift to the floating exchange rate system advocated by the greatest critic of Keynesian economics, Milton Friedman.

In the course of the 1970s, Friedman and his supporters, centred on the University of Chicago, won a series of political and intellectual victories over the Keynesians. Following the failure of attempts to stabilise the economy using Keynesian fiscal policy, governments around the world switched to Friedman’s preferred remedies based on controlling the growth of the monetary supply. Even though this did not work particularly well, and was later replaced by policies based on managing interest rates, the resurgence of the Chicago School was not reversed.Their case against government intervention, both to stabilise the macroeconomy and to address market failures in particular industries, was widely accepted.

The Keynesians conceded Friedman’s central points: and that macroeconomic policy can affect real variables, like the levels of employment and unemployment, only in the short run. They sought to develop a ‘New Keynesian’ economics, by showing that, given small deviations from the competitive market assumptions of the basic neoclassical economics model, it would be possible to explain the recurrence of booms and recessions and to justify the modest stabilisation policies pursued by central banks during the Great Moderation. Because prominent representatives of this group were located at Princeton and Harvard on the East Coast of the US, and at Berkeley on the West Coast, they were sometimes called the ‘saltwater school’ as opposed to the ‘freshwater school’, located in the lakeside settings of Chicago and Minnesota.

Members of the freshwater school sought to push Friedman’s conclusions even further, arguing that macroeconomic policy could not be beneficial even in the short run. They tried to show that government intervention could only add uncertainty and instability to the economic system, and that, in the absence of such intervention, economic fluctuations like booms and slumps were actually good things, reflecting economic adjustments to changes in technology and consumer tastes. The resulting models went by various names, but the most popular was ‘Real Business Cycle Theory’.

Despite their often heated disagreements, saltwater and freshwater economists were in agreement on one fundamental point: that macroeconomic analysis must be based on the foundations of neoclassical microeconomics. And, although they disagreed about economic policy, these disagreements could be contained within a very narrow compass. With a handful of exceptions, both schools took it for granted that macroeconomic management should be implemented through the monetary policies of central banks, that the only important instrument of monetary policy was the setting of short-term interest rates and that the central goal of monetary policy should be the maintenance of low and stable inflation. Granting these premises, saltwater economists argued that stability could only be achieved if central banks paid attention to output and employment as well as inflation, while the freshwater school favored an exclusive focus on price stability.

The global financial crisis did not so much confirm or refute the elaborate arguments of the competing schools as render them irrelevant. The saltwater school could claim vindication for their view that the economy is not inherently stable, but their models had little to say about the kind of crisis we have actually observed, driven by an interaction between macroeconomic imbalances and massive financial speculation.

The freshwater-saltwater disputes were similarly irrelevant to the policy debate which was conducted in terms that would be familiar to someone who had not looked at an economics book since 1970. (In fact, the freshwater side of the dispute rapidly reverted to arguments from the 19th century, which had been debunked by Keynes and Irving Fisher).

As Gregory Clark of UC Davis observed ‘The debate about the bank bailout, and the stimulus package, has all revolved around issues that are entirely at the level of Econ 1. What is the multiplier from government spending? Does government spending crowd out private spending? How quickly can you increase government spending? If you got a A in college in Econ 1 you are an expert in this debate: fully an equal of Summers and Geithner.’

If we are to develop a macroeconomic theory that can help us to understand, and hopefully prevent the recurrence of, crises like the current one, and help us to improve policy responses, economics must take a different road from that it has followed since the 1970s. The appealing idea that macroeconomics should develop naturally from standard microeconomic foundations must be recognised as a distraction. In its place, we must accept, in the language of systems theory that macroeconomic phenomena are emergent, arising from complex interactions of behaviors we do not fully understand, but must nevertheless respond to.

The first part of the title is ironic. The paper is about 12 economists who did see the crisis coming. Steve Keen gets a mention and I for one can’t blame him for blowing his trumpet a little. John Quiggin probably made some predictions which might well qualify him for this list too? JQ, can give any links back to any of your predictions before the GFC?

More pertinently, JQ, do you count yourself (in terms of general theory and praxis) among these heterodox economists?

The problem I have is that you make a distinction between a free market economist and new Keynesians and you assume that these two ingredients make up the bulk of the academic literature.

In fact, there has always been a second school of new Keynesians – one that, while it generally relies on the all-powerful Central Bank to step into the breach, it also makes provision for a larger fiscal role in cases where the Federal monetary role went off the rails.

Fiscal intervention can be done with the aid of taxes and spending to smooth out short term fluctuations (called contra-cyclical policies) or it can be done through “discretionary” measures which involve new tax or spending policy initiatives. This has largely been a formal part of Treasury’s literature, which has always insisted on contra-cyclical policy.

I like your clear statement on the need for new theoretical research and your preference for rigorous theoretical research. There is one point though, which I believe opens the way for more school of thought talk. It concerns the term ‘neo-classical’. I have no reason or evidence to believe that this term is unambiguously defined, although it might be useful for authors of books on the history of economic thought as a name for a historical epoch.

I think, in this chapter, you could discuss, briefly, misapplication of the ‘moral hazard’ argument.

A problem with the ‘moral hazard’ argument for not bailing out a bank is that it is individuals that make decisions, not an entity like a bank. Lehman Brothers not being bailed out might have punished the bankers who made the bad decisions to a small extent, relative to not bailing them out, but the decision of not bailing them out punished an incredible number of innocents. First, the shareholders and more junior staff were relatively innocent victims, but more importantly the rest of the world that has been suffering the repercussions since, most of whom were totally innocent. The ‘moral hazard’ argument in these circumstances is nothing more than a collective punishment argument. Unfortunately, unlike the Nazi use of collective punishment in WWII, I don’t think those who made the bad decisions really care that much about those who have been punished collectively. Moral hazard would be better addressed by changes to laws that allow the decision maker to be punished for foolish and negligent decisions. I doubt that this will happen because who will finance the lobbyists for this law change.

@Freelander
Watch it Freelander or someone will mention that that silly Godwins law (real soon…) I was going to suggest myself, collective punishment isnt really the same as letting Lehman’s fail. The only moral hazard I can see was when we let Goldman and AIG stay with taxpayers help. I have a moral objection to that and they are still a hazard.

We have to let AIG and Goldman stay with taxpayers help, unfortunately. However, those at the top should have lost big and shareholders should have lost their shirts and bondholders too, according to any short falls. The government should have taken it over and, as required to keep the system going, guaranteed those who had purchased their products. That protects the systemic risk. Unfortunately, to save people from the systemic risk those at the top got generous bonuses. To do it the right way the law has to be different. A government regulator has to be able to step in in a way that does not reward poor management or shareholders or bondholders, but which does address the system wide risks. And I agree they are still a hazard, but if they too failed we would be in a worse situation and when it is all over it would happen again with new firms with new names.

I think that it is now clear that the models of Neoclassical Economics are falsified. They fail to describe the empirical reality of the economy and they fail as predictive theories. If some are not happy with the tag “Neoclassical Economics” then we can say that Equilibrium modelling in economics has been falsified. In the long term, a move to non-equilibrium modelling will be required to maintain policy relevance.* What I am saying is that policy relevance, real or perceived, must be grounded in empirically validated theory or it is ultimately worthless.

* I’ll put one caveat on that. Globally, due to idelogical and religious reaction, we might not move to empirically based models for our economic and climate programs. However, if we fail to so move then there will be NO economy and NO global civilization left to speak of at all.

By the way, I had no intention of comparing the former US Secretary of the Treasury to a Nazi, even if some think his then leader resembled a certain person with a moustache. I was just making the point that if you want collective punishment to work, those you really want to punish must have some emotional connection to those being punished.

Collective punishment was used by British colonists as they rampaged through Aboriginal lands from 1788 to 1920’s. It seems to always suggest violent retribution – not merely shifting costs/harm onto univolved innocents.

It seems a strange device to explore the issues of bailout and moral hazard?

Further, Ikonoclast, I don’t believe hat the methodology of natural science is ever going to be a role model for economics. In contrast to water, which always flows down hill, a human being can walk half-way down hill and then turn around and walk up again.

The purpose of some models is merely to develop useful concepts. Their usefulness derives from a check on their internal logical consistency within the context of a model. For example, in the link referenced by JQ there is a national accounting identity. This is an equilibrium condition. JQ says that there is no particular theory underlying it. Well, in some sense I agree. But in another I don’t. On what grounds are the categories picked?

You can sail a yacht without adjusting the main but you won’t win races. Perhaps the same could be said about countries using central bank interest rates as the sole means of economic control. This is particularly true when central banks ignore the globalization of the world economy and persist on trying to control inflation measured in terms of the currency of their countries. (Instead of some trade weighted measure based on the currencies of the countries they trade with.
It is suggested that part of the cause of the GFC was the combination of large, chronic, unsustainable trade deficit on the part of the US and the large, chronic, unsustainable trade surpluses of China and Japan. The problem was recognized well before the GFC but action solve this problem was inhibited WTO rules that were based on an almost religious belief that free markets were the answer to everything.
I am not suggesting that we go back to the economic world as it was in the 1960’s. What I am suggesting that economics needs to become more nuanced and pragmatic and less driven by those seeking the economic answer to everything.
For example, we certainly need WTO policies that allows countries like the US and Australia to deal with their chronic trade deficits. (One of the ironies of the WTO is that a key argument for free trade is that it encourages innovation – While WTO rules are all about restricting what countries can do to solve their trade problems.)
In Australia, we need to insist that the Reserve Bank, Free Trade Commission and government have to be part of the same team. It is ridiculous to have the government working to stimulate the economy while the reserve is already talking about slowing the economy down.
It was also ridiculous to have the Reserve bank putting on the economic brakes during the recent boom while unemployment was still over 4%. All this did was take the pressure off business to make more effective use of the low skilled people in our society. Staying with inflationary pressure for longer may have allowed us to build a less inflation prone economy.

I think the trade deficit story is just a ‘lets blame the Chinese’ story. In fact the US should be happy that the Chinese have been so generous in subsidising them and now have a major problem in getting their trillion dollars back intact. The low interest rates etc. certainly helped things, and the main culprit there was monetary policy, but the real problem was the clever commission and bonus motivated decision makers introducing the lending of money to people who obviously couldn’t pay, in a way that wouldn’t become undeniable for a couple of years, and then recycling those mortgages as triple A bonds (with the help of rating agencies) using the magic of CDOs and CDSs so they could get more money to do the same thing with. It had all the hallmarks of a Ponzi scheme. Poor Bernie is in jail for a similar rort but the evil doers in this case (to use a Bushism) don’t even have to worry about the law and have most of their money in the case of Lehman Bros or are getting bonuses in the other cases.

Re: co-ordinating fiscal policy with the Reserve Bank, I think they are doing fine. The Reserve Bank is only talking about starting to bring interest rates back to more normal levels next year and, after all, Ken Henry is one of the board members so it is not as if Treasury and the Bank don’t talk and try to co-ordinate. Over dramatic use of monetary policy (in the US) is one component of what got us in trouble in the first place. For over dramatic use of monetary policy look at the history across the Tasman, particularly under Brash. Loose monetary policy doesn’t seem so good at fixing an ailing economy but tight monetary policy sure can kill a healthy one. And loose monetary policy creates inflation or bubble problems when an economy starts off just fine. I think our Reserve Bank has a pretty good record of handling monetary policy without unnecessary drama.

@Freelander
Freelander – by saving Goldmans and AIG we have provided an impicit guarantee that the same faulty methods will continue in our financial markets. We guaranteed the biggest will not be made to carry the consequences of their own risk taking and excess surplus removal (remunerations) from the companies they pretend to run for the benefits of shareholders. We have, through “protection”, protected the very behaviours that caused the financial crisis.

I know it would have caused pain (lots), but it might have made every other complacent well fed (too well) financial executive sit up and pay attention to whats appropriate in running a company on behalf of shareholders and what isnt.

Lessons if you like, collective punishment of you like, but what on earth are we doing bring back the anti christ of protection when these are the very people who said they didnt need it and we didnt need it. If its protection we are resucitating, let it go to small businesses not large ones.

They can fail IMHO. I dont care who they are connected to by power and influence and financial trading links. We do not need them as much as we think. We just never tried to do without them and we should. This is nothing more than the tariff walls of the 1920s only we have built those same walls around one sector and one sector alone. In lots of ways its not even as fair or equitable as the protection of the 1920s. Itds enslavement of taxpayers to those who never needed it for any productive reasons.

The problem is that the ones that make the decisions almost alway walk away largely intact and with most of their ill gotten gains. Most of those at the top of Enron are still quite wealthy with the money they got from running Enron. Same is probably true with those from Lehman Bros. Thats why there needs to be new laws, and significantly sizeable punishments, so that when they do the wrong thing they do end up making a loss. As it stands at the moment even if the worst happens to them they come out ahead. Under these conditions there is no reason for them to change their behaviour. That’s why the moral hazard argument is so totally vacuous. Sure it may mean they miss out on one more round of unearned bonuses but to do that it creates an incredible amount of collateral damage. For much of business doing the wrong thing even if you get caught is profitable. A good example of that is a certain software company.

@Freelander
Well that is interesting Freelander …of course they walk away. I wonder where the management of Long Term Capital managemnt is today, I wonder where Michael Milken is today, Bond is out of jail, Rivken is dead but only did weekend detention, Skase is dead but never got before a court, Bloody Jodie Rich has managed to avoid jail time, Eddy Groves isnt anywhere near a jail yet (nor is he likely to be), Rodney Adler – is he out (what does it matter – he is still in business)? What about the HIH gang? Where are they? Richo the “persuader” ex “offset alpine profiteer and tax scammer” now in bed with the wealthy property developers, Ells and McGurks and that other one who dines at the Forum in Leichhardt. Hellicar, the most morally bankrupt blonde in corporate life that ever breathed has been slapped with a lecttice leaf.

They keep walking away with dirt on their hands in this country and a bare whisker of a reprimand.

Corporate crime has no effective punishment (at least not in Australia – the land of the free).

John, it’s interesting that while the macro wars have started again (a bit like the Hundred Year’s War, a series of on- and off-again conflicts), there are never any micro wars. Yet, if representative optimising-agent macroeconomics has failed as an explanation for the whole economy, why hasn’t optimising-agent microeconomics failed as an explanation for firms and industries?

It is this microeconomics that forms the basis of the design of emissions trading schemes (or carbon taxes), proposals to tax traffic congestion, indeed pretty much all of tax policy, proposals to break up Telstra, and so on. There is a lot at stake.

Assuming that neoclassical economics is just fine, for practical purposes, for analysis of firms and industries (yes I know you can’t aggregate individual demand functions to get market demand functions except in special cases; no one cares in practice), just what is it about the whole economy that turns a useful body of analysis into something worse than useless?

Maybe (to reprise the literature of the 70s and 80s) it’s because for macro you need to incorporate money in the analysis, but money is conveniently not needed for micro. But this is just re-stating the question.

@Freelander
The trouble with depending on interst rates changes as the major tool for controlling the economy is that it is a blunt instrument that causes a lot of collateral damage. For example, increasing interest rates may slow down inflation measured in terms of $Aus but it contributes to inflation when it is measured in terms of the currencies of our competitors and customers as well as inflating the cost of capital for Australian companies that have to compete in the global economy. Hardly a good result for a country with a chronic balance of payments problem

In addition, changing interest rates is not the only tool that can be used to fight inflation. It will often make more sense to understand what is causing a particular burst of inflation and then take appropriate targeted action.

We need a team effort to handle the economy and a willingness to use a wide range of solutions to our problems of inflation, trade balance etc. We are not going to get the best solutions while the RBA feels free to change interest rates without the agreement of the economic team or the government.

In its place, we must accept, in the language of systems theory that macroeconomic phenomena are emergent, arising from complex interactions of behaviors we do not fully understand, but must nevertheless respond to.

So given all these dead ends, what are the most promising research programs in macroeconomics today? And do you see academic conservatism as an obstacle to their development?

Gerard, to be precise, you can’t be sure that you can aggregate individual demand functions to get market demand functions, except in special cases. But it could still happen in theory, and in practice, market demand functions do tend to look like what you would expect them to look like if you could aggregate.

@John Davidson
I agree John Davidson – inflation is a complex animal – it can affect different commodities or be only driven by one input and not others…its interesting that inflation can take these quite different forms (and be driven by one resource even) but the treatment by central banks is actually very blunt as you say.

Could I suggest that the problem is not that macro models are/aren’t derived from micro foundations, but the “neoclassical” nature of those foundations.
By contrast, there is a growing area of econophysics and of political economy devoted to micro-agent-based modelling/simulation of economies on the assumption that the micro agents act more or less at random, or according to simple rules, yet which still produces rich and emergent macroeconomic phenomena.
The difference is that a simulationist method is not wedded to the idea that the economy is one rational individual writ large (one consumer purchasing one commodity, as Steve Keen puts it). The research program is explicitly modelled upon the thermodynamics of gases, where the random behaviour of umpteen individual molecules nevertheless leads to simple ideal gas laws.
See the recent comment article in Nature, The Economy needs Agent Based Modelling, the seminal book by Moshe and Machover Laws of Chaos: A Probabilistic Approach to Political Economy (whole book available as pdf) and the recent paper by Wright, Implicit Microfoundations for Macroeconomics.

nice links James. I had the Santa Fe people and ABCE in mind when I was asking Prof Quiggin about what he saw as being the more promising directions in future research, although I think some work by Krugman and others on the spatial economy also deals with emergent phenomena and is inspired by mathematical ecology. The thermodynamics of gas have inspired current research in the modeling of traffic and I’d expect that this sort of thing would have already broken into the mainstream of economics more than it has.

But Krugman also pointed out (and if I had time I’d google the quote), that you don’t get tenure or top-journal publications by coming up with something new and interesting, but by making minor embellishments on what is already well established.

I think that the idea that the neoclassical foundation that “the economy is one rational individual writ large” is what Uncle Milton meant by “special cases” – the Sonnenschein-Mantel-Debreu condition that everybody has identical preferences allows individual demand curves to be aggregated into a country’s demand curve. But as computers become more powerful I would expect modelers to stop relying on that type of simplification.

Ernestine, strictly speaking I am a layperson on economic matters so I may be talking through my hat. Having said that, I have a basic tertiary degree (BA) and this did include literature, media and science subjects. I have also read extensively out of my specific subject areas and might mention authors like Adam Smith, Marx, Bacon and Hume.

Based on my general understanding of the arts and sciences I try (in matters in which I am still a layperson) to assess the various claims of exponents in various fields, for example in climate science or economics.

My touchstone is empiricism in general and scientific empiricism in particular. I’ll let the Wikipedia sum it up for me or rather us.

“In philosophy, empiricism is a theory of knowledge which asserts that knowledge arises from experience. … Empiricism emphasizes the role of experience and evidence, especially sensory perception, in the formation of ideas, while discounting the notion of innate ideas (except in so far as these might be inferred from empirical reasoning, as in the case of genetic predisposition).

In the philosophy of science, empiricism emphasizes those aspects of scientific knowledge that are closely related to evidence, especially as discovered in experiments. It is a fundamental part of the scientific method that all hypotheses and theories must be tested against observations of the natural world, rather than resting solely on a priori reasoning, intuition, or revelation.”

I understand your general objection to my line of reasoning but I don’t accept your objection in toto. You complain that, Ernestine, strictly speaking I am a layperson on economic matters so I may be talking through my hat. Having said that, I have a basic tertiary degree (BA) and this did include literature, media and science subjects. I have also read extensively out of my specific subject areas and might mention authors like Adam Smith, Marx, Bacon and Hume.

Based on my general understanding of the arts and sciences I try (in matters in which I am still a layperson) to assess the various claims of exponents in various fields, for example in climate science or economics.

My touchstone is empiricism in general and scientific empiricism in particular. I’ll let the Wikipedia sum it up for me or rather us.

“In philosophy, empiricism is a theory of knowledge which asserts that knowledge arises from experience. … Empiricism emphasizes the role of experience and evidence, especially sensory perception, in the formation of ideas, while discounting the notion of innate ideas (except in so far as these might be inferred from empirical reasoning, as in the case of genetic predisposition).

In the philosophy of science, empiricism emphasizes those aspects of scientific knowledge that are closely related to evidence, especially as discovered in experiments. It is a fundamental part of the scientific method that all hypotheses and theories must be tested against observations of the natural world, rather than resting solely on a priori reasoning, intuition, or revelation.”

I understand your objection to my line of reasoning but I don’t accept your objection. I think philosophically and empirically it is refutable. You said “I don’t believe that the methodology of natural science is ever going to be a role model for economics. In contrast to water, which always flows down hill, a human being can walk half-way down hill and then turn around and walk up again.”

Let us examine your statement. In simple terms you are saying one of two things.

(A) Hydraulics is simple (relatively speaking). Human behaviour is far more complex. Both are natural phenomena but there are far too many unknown variables to predict human behaviour.

(B) Hydraulics deals with physical phenomena. Human behaviour is influenced by more than physical phenomena. Thus it logically follows that human behaviour is influenced (at least partially) by other phenomena of metaphysical or supernatural origin.

If your proposition is (B). I can say that I respect your position (though I do not agree with it). Further I would say that you are being logically consistent with respect to your a priori assumptions.

However, if your proposition is (A), you need to show more caution about assuming that human behaviour (singly or in aggregate) is too complex and unpredictable to be amenable to explication by the methods of natural science.

Without letting this answer drag on too long, I would say that mass behaviour of humans and their various economic systems can almost certainly be found to obey system-specific laws. (I mean laws true within a certain general system like Western Capitalism.

The problem with equilibrium models of the economy is that they don’t match reality. These models are unempirical. The real system does not act like any of the equilibrium models. If any model does not model reality then it is an academic exercise at best.

@fredn
Fred – you only need read about the company Kates keeps and where he publishes…

Kates is a stooge writer for Quadrant..you may as well write him off ..one of those who keep yelling “lower taxes lower taxes”…the same type that seem to think CEOs salaries are competitive and workers should have no rights..

Enough said…and he apparently mistakenly thinks he has a clue about the business cycle but I bet he didnt see GFC coming …oh no. Likely a waste of acedmic space.

I agree that interests are over used by central banks around the world. I don’t agree that the RBA tends to willfuly work at cross purposes to sensible actions by Treasury and Government. If the Government willfully persists in doing something silly, however, I think the RBA, to the extent that voting of the board allows will try to mitigate the harm that is done.

Amongst the tendency to over use of monetary instruments by central banks, I tend to prefer our RBA to say the NZ equivalent or the Federal Reserve in the US. The RBA tends to use a much more steady hand. And this is good because changes to interests rates can turn profitable businesses into bankrupt ones or encourage unwise borrowing and asset bubbles, the collateral damage you mention.

I agree there are other instruments. But I think that monetary instruments are still important, long term, when it comes to keeping the inflation rate stable. I suspect that they tend to be overused for fine tuning.

@fredn
Fred – This Kates guy is now busy writing pretty uninspiring articles for Quadrant attempting to turn the blame for the GFC from the over liberal liberals and mad de-regulators and excessive money flowing to the wealthy from the Wall st casino and an eroded tax constraint on them (the wealthy) ….to …wait for it…Keynesianism.
No they dont want Keynesianism, even if it works much better than the nonsense theories Quadrant have been publishing for Corporatesville and Coalsville and the right dishonourables for god knows how many years now. Quadrant and IPA publish garbage, using lackeys posing as academics for their masters, usually large employers like CEOs and Sir Lunchalots who usually have their hands in the economic till big time and they dont want to take them out and see a more balanced approach.
The amazing thing is the articles are never very well written either..must be on a piece rate.

@Freelander
We have run with a chronic balance of payments problem for years. To make matters worse the RBA has had Australian interest rates well above the OECD average every time I have looked. My perception is that central banks were spooked by stagflation and haven’t really understood how the role of interest rates has to change in a more globalized, freer trading world.

Perhaps my problem is that I’m a chemical engineer who has spent a lot of time sorting out control and other problems. I guess I would hate to have been a problem solver who wasn’t allowed to consider some solutions because they didn’t have the big tick from the fossils in the Chicago school of chem eng.

Perhaps you should be asking how our economic management system should be set up to seek out and implement the best answers to controlling the economy? I would be disappointed if your answer was a system that gave the RBA control of interest rates.

@John Davidson
John – I imagine there would be no greater torture for a problem solver..(waiting for a tick from the Chicago school of chem engineering – especially if you thought the Chicago school were absolutely terrible engineers).

@gerard
Gerard, Krugman has indeed done some interesting work with similar emergent models in his spatial economy studies; which makes it all the more a shame that he’s not going the whole hog now, instead saying “I, for one, am not going to banish maximization-and-equilibrium from my toolbox”. If he did, he could drag half the profession with him and become the 21st century’s paradigm-shattering John Maynard Keynes, IMHO. Instead, as Keen points out, it seems like he’s never going to get the complex systems thing.
On the other hand, I don’t have a pseudo-nobel or a record of successful predictions as Krugman does, so we shall see!

I think far to much notice has been taken of Milton Friedman’s ideas and have little time for the Chicago Collective (or School as it likes to call itself), but that doesn’t mean monetary policy is totally irrelevant. As recent event have demonstrated, for the problems we were/are in fiscal policy was the solution. As for long term interest rates, Australian rates have been higher, on average over the years, than US rates because the Americans have been subsidised by the rest of the world using them as a reserve currency. Savings rates, the size of the economy, stability of the exchange rate and many factors come into play in determining long term interest rates. The central bank has limited influence over keeping the long term interest rate down, below a certain point, over the long run. It is just not something they can control over the long run. Except to do harm.

@SG
Sean – you say “Rushing headlong into the “fiscal policy is always the solution” crowd is very dangerous for the long-term health of an economy.”
Sean G, I havent met a single soul like that in here (and if you can point one out Ill put a bet against) but I have met plenty of liberals who want no intervention at all..half the problem of economics is the extremism of the tribes. Original message lost and the tribes worship effigies. In my view, there has been overreliance on a de-regulation, freeing of markets, privatisation of public sectors pervading policy for at least 30 years and a strong preference for the dabblings of the all powerful RBA and its inflation target (who is watching unemployment here?) notwithstanding concurrent use of fiscal policy. I dont think anyone really advocates “fiscal policy is the only solution” but to get some balance back and some broadening of the indicators (like unemployment, rising inequality) which are actually taken into account in policy would be much more sensible.

Usually I would place this in the Weekend Reflections thread – but it doesn’t seem to have be provided recently… Hope JQ doesn’t mind… :))

I have just published a new entry on the Left Focus blog. The entry considers recent commentary by the important progressive US economist Joseph Stiglitz. Specifically I address arguments regarding whether or not GDP is the most appropriate measure of social and economic progress.

Furthermore I consider the case for further economic stimulus – in Australia, in the US – and worldwide…

Your contributions to the debate would be welcome – either at our Facebook page- or better still at the Left Focus blog itself…

Tristan Ewins, I’m sure the host welcomes you but as for the economic stimulus it should be viewed as a ‘Keynesian economic miracle’ for if market forces were left to their own devices then the world would have entered into a long and protracted worldwide recession and possibly a deep depression.

At the risk of repeating myself, I want to take issue (once again) with Ernestine’s refusal to accept “neoclassical economics” as a term for a definable school of economics. I hope we can debate this politely but robustly. Ernestine, I find your resistance to this term scientifically and philosophically untenable. However, I may have misunderstood the grounds of your rejection. Bear with me as I argue this through. Do you also resist all (or some) other general labels such as Classical, Marxist, Keynesian, Austrian, Monetarist, New Keynesian etc.?

Neoclassical is a broad term for sure. To take some examples from other fields, if we are to reject a term like “neoclassical economics” then we would also have to reject a term like “Protestantism” or even contrasting terms like “plants” and “animals”. In doing so we would be rejecting a standard method of classification which applies not only throughout the sciences but also through much of philosophy and the humanities. This is the process of classification first by major divisions based on shared major characteristics and then on down through the sub-divisions of shared intermediate and finally minor characteristics. Biology provides a well known example with the current Linnaean or perhaps I should say the “New Linnaean” system.

If a person refuses to accept both the general convention and the specific pragmatic values of classification or if that person refuses to accept an otherwise widely accepted term (in both academic and lay literature) then this can render it impossible to engage that person in logical debate in the arena of the disputed term or terms. There can be cases where refusal to accept a term is defensible. This refusal, to be defensible, must be based on a rejection of the term for being idiosyncratic rather than generally accepted, or on the term being an outcome of a demonstrable misclassification, or on the term being an outcome of spurious differentiation. I do not accept that the rejection of the broad term “neoclassical economics” (for a broad school, “phylum” or perhaps “class” of economic theory) fits any of these defensible rejection criteria. However, Ernestine, you may be able to offer an argument in this area.

Often, lacking a defensible rejection as above, the refusal to accept a term reveals a refusal to debate what the holder self-perceives as a “natural” and thus undebatable position. This often occurs in the arenas of ideology, religion or political economy where a personal belief system (self-perceived to be absolutely true, natural and unquestionable) is threatened by any attempt at debate. Debate is shut down before it can begin. The neatest way is to deny that the opponent’s terms have any meaning content. Thus if a person believes there is only “economics” (in the sense of current mainstream economics) then from this “self-evidently natural” viewpoint the attempt to delineate major defining characteristics and thus different schools of economics is ruled out of court straight away. If a person is raised and educated exclusively in one culture that person simply cannot conceive that other cultures exist. Further that person cannot recognise that their own culture is particular and peculiar and requires a defining label for shorthand reference just as tables and chairs require defining labels. However Ernestine, this may be an unfair characterisation of your position. I await replies on this and other points.
The Wikipedia states;

“As expressed by E. Roy Weintraub, neoclassical economics rests on three assumptions, although certain branches of neoclassical theory may have different approaches:
1. People have rational preferences among outcomes that can be identified and associated with a value.
2. Individuals maximize utility and firms maximize profits.
3. People act independently on the basis of full and relevant information.”

From these normative abstractions (which empirically speaking are quite absurd), neoclassical economics has developed the general equilibrium model. Ernestine has challenged me to nominate which particular equilibrium model I am referring to. Frankly, I must admit I am on shaky ground here. I am, as I admitted, a layperson in economic matters. I only have one life (an argument JQ advanced on his own behalf in another context recently in this blog) so I cannot for example become expert in economics or climate science as well as follow my own fields and endeavours. There are only so many hours in the day. Thus in economics I cannot necessarily nominate species of equilibrium models just I cannot nominate all the physical equations necessary to prove the greenhouse hypothesis.

Nevertheless, in each case, as a BA in the arts and sciences, I can apply my general philosophic and scientific understanding to assess the arguments of experts (and cranks) in each field. As I noted in an earlier post, my touchstone is empiricism in general and scientific empiricism in particular. I also understand that philosophical, metaphysical and speculative theories are necessary too. I understand that some of these theories may progress to the point of being proto-scientific theories and eventually scientific theories. (I follow Karl Popper in this regard.) I assess the general theories and hypotheses of experts and cranks (without prejudging which is which) in these and other fields by the following general criteria.

1. Is the theory philosophical, metaphysical and speculative? Does it show evidence of major unempirical, normative, essentialist or a priori assumptions?
2. If the answer to 1 is “yes”, does the theory explicitly recognise this aspect of its own nature or does it deny its own metaphysical assumptions?
3. If the metaphysical theory recognises its metaphysical assumptions it may yet be useful as general philosophy or even useful specifically as a guide to developing at least a proto-scientific theory.
4. Excluding the above, is the theory empirically based and thus a scientific theory amenable to empirical testing?
5. Does the general theory and the data gathering and testing of that general theory (where I am not a specialist in that particular field) fit with my general understanding of the scientific method?
6. Does the theory make predictions and are these predictions being borne out by subsequent data?

Taking those above criteria and applying them to climate science and “neoclassical economics” respectively, I can make the following judgements. Climate science is a science. “Neoclassical Economics” is an abstract, metaphysical and unempirical model which furthermore fails to explain the empirical events in a real economy. Equilibrium modelling of the economy (in any specific form) is now a fully refuted approach. Whilst making this judgement, I do not make the a priori assumption that Ernestine seems to do in implying that economics can never be scientific or at least have scientific or quantifiable elements. Dynamic modelling of the sort being undertaken by Steve Keen promises to be a far more fruitful approach and already deserves the title of a proto-scientific theory which “neoclassical” or “orthodox” economics does not.

Ernestine’s example (comparing water flowing all the way down a hill to a man walking half way down and then walking back up) is actually a marvellous analogy for the boundary between hard scientific and philosophic enquiry and the need to be aware of both and the uses of both. The behaviour of the water we can take as being describable by hard science equations. The behaviour of the man is an aggregate and part of it perhaps cannot be described (as yet anyway) by hard science. However, if we look at the man and designate the source of his volition as an “x factor” of unknown origin and operation we can still examine much of the rest of his actions in hard scientific terms. For example, we can use various methods to calculate the energy he uses in walking halfway down the hill and walking back up it. We can scientifically describe how his body gets this energy from food and uses it in the muscles. We could go on.

We could even begin investigating if his volitional behaviour (for want of a better term at this point) is as mysterious and capricious as it first appears. With repeated observation we might find that turning midway to walk back up the hill is based in a statistically significant way on certain attractive or repulsive stimuli. A pretty girl appears at the top of the hill and calls out to him. He goes back up. A loquacious professor with antediluvian theories appears at the bottom of the hill. Our man turns back and scurries over the hill to make his escape. Alternatively, he may have been told walk up and down the hill randomly for an experiment and thus may be attempting consciously to make random decisions. With enough data it might be interesting to discover whether his decisions are truly random or show patterns in themselves or correlations with external events despite his instructions.

I would be interested to know whether Ernestine accepts or rejects rational preference and utility maximisation theory (leaving aside whether we call it “neoclassical economics” or not. Ernestine’s implied rejection of strict determinism and scientific quantification in her man-on-the-hill analogy would also imply a rejection of Weintraub’s points. Let’s look at them again.

1. People have rational preferences among outcomes that can be identified and associated with a value.
2. Individuals maximize utility and firms maximize profits.
3. People act independently on the basis of full and relevant information.”
Points one and two have a distinctly robotic and deterministic flavour. There is also a strange sense of inherent contradiction. Human agents are free and rational therefore they MUST at all times behave in a rational, utility maximising manner. There are so many philosophical and definitional problems along with normative assumptions and internal contradictions affecting these statements that they can be comprehensively demolished but it would take too long here and now.

The final clinching point is that these essentialist assumptions are unnecessary and even obstructive to any proper research program. We make no essentialist assumptions about the “will” or “motivation” of atoms in physics and we should make none about humans in economics. In each case we should observe behaviour and correlations and develop (if possible) dependable laws. Then we should test those laws against long run empirical reality. Essentialist assumptions or investigations into human rationality, emotion, logic, will and so on belong in philosophy and in psychological novels but not in economics.

Micheal, If God works in mysterious ways how do you know part of his mind? That is to say, how do you know whether or not he discriminates when it comes to socialist policies? (Never mind what you actually meant by that phrase because I don’t understand it.)

“If we are to develop macro theory that can help us understand and hopefull prevent a crisis like the current one, we need to read Mises, Rothbard, Minsky and Steve Keen and reduce leverage and return to a gold standard, and thereby make most economists, bankers and govt financial bureaucrats redundant, so they are forced to work in the real world, as accountants, book-keepers, or garbage collectors.”

Alice, there’s a thank you gift at the Sydney Uni Economics Dept for you. Go there now and collect it.

A version of the “great” macro debate – scaled down, but still retaining the signature definitive pronouncements – is even getting a run in the Senate economics committee with the Rudd stimulus declared by Steven Kates and Tony Makin to be, at best, a complete dud, driven by clearly debunked theory. Reported in The Oz here.

Impartial as always, The Oz does note in the closing paragraph that an opposing view does exist that was also put to the committee.

In my last post #49 I nearly painted myself into a corner. That’s always a danger when blogging one’s views extempore. I said in essence that assumptions or investigations into human rationality, emotion, logic, will and so on belong in philosophy and in psychological novels but not in economics. My main get out of jail card is that I wrote “economics” not “political economy”.

The overall debate (on JQ’s analysis of dead economic ideas) turns on two questions. What is economics? What is political economy? In answering these questions we must sketch out the arenas of political and moral philosophy on the one hand and the arena of scientific economics on the other.
What is economics?

Economics is the proto-scientific or scientific study of the production, exchange, distribution and consumption of goods and services in a human society under a given cultural-political-administrative-regulative system. My definition here is more specific than the standard social sciences definition. I caveat my definition by indicating that the attempt to find economic laws is assayed under a given “political system”. From now on, “political system” will be shorthand for the cultural-political-administrative-regulative system of the society in question.

What is political-economy?

Political economy is a necessary and necessarily hybrid subject embracing moral philosophy, political philosophy and economics.

What is the value of separating “political-economy” from “economics” as a subject area? Or more specifically and precisely what is the value of essentially making “scientific economics” a set of sub-group “slices” within the broader subject of political economy? The best way to answer this might be to refer to the scientific method of measuring the characteristics of gases and liquids. To obtain consistent and comparable results, experimental measurements are made under standard conditions normally referred to as STP (standard temperature and pressure). Economics can only attain a scientific status by following the same method. Namely, laws and standard characteristics can only be derived relative to the entire “environmental” conditions namely the conditions of the real physical environment and the conditions of the political environment. That is, an economic “law”, discovered to reliably express the relation between two quantities, will be valid only for a given set of environmental and political conditions.

Even so, the close to absolute precision of the basic hard physical sciences will never be repeatable in economics neither in defining conditions nor in defining its condition dependent laws. This is not an argument against this method. Uncertainty and measurement error exist in all sciences. The issue is not that uncertainty and measurement errors exist but that dependable laws can be discovered for defined conditions and that these dependable laws (which may be expressed in probability terms rather than absolute certainty terms) can be used to predict certain events with statistically acceptable reliability.

This approach to political economy and economics may be contrasted with the dishonest orthodox or neoclassical approach. My advocated approach recognises that economics is determined not only by the actions of the actors (economic agents) in it but by the “conditions box” around it. This conditions box comprises physical and socio-political reality. The approach of orthodox or neoclassical economics (at least in their more extreme neoliberal forms) is dishonest because it essentially propounds that there is a pure or ideal economy which will come into existence if only politics will get out of the way. It posits this pure or ideal economy as being essentially stable, in equilibrium and equilibrium seeking. Perturbations and disturbances, booms and busts can only occur because of exogenous disturbances. Since the physical environment and its constraints are always ignored by neoliberal neoclassical economics (another clear sign of its unempirical nature) then these exogenous disturbances can only come from politics. If only politics would get out of the way and leave the economy alone (i.e. leave the rich and powerful actors alone) then the economy would perfect itself.

This view of economics pretends to be value-free (un-ideological) but in reality it is profoundly ideological. It cannot recognise its own nature as a metaphysical and moral philosophy system. It wants to propound that economics and not political philosophy, democracy in our case, should lead society. In its view politics should get out of the way. Of course, this is a way of having a pure political agenda whilst pretending there is no political agenda at all. The alternative view of defining political-economy and economics separately, of recognising politics (and physical reality) as setting the pre-conditions for economics, allows for consciously political-democratic decisions to set the conditions we think we need. Then scientific economics (dynamic modelling, hypothesis testing, data gathering and confirmation or refutation) has its role and field within that condition box. If we don’t get some of the results we predicted and desired we democratically change some of the political conditions with our opinions modified and guided by empirical results, experience in other words.

This implies a somewhat tinkering, gradual, eclectic, mixed political-economy but always empirically guided approach to the whole effort of developing a good economy. But then it’s kind of like the difference between the man who says he knows the way to utopia and then strikes out in one unalterable direction with closed eyes and the man who says he knows the basic method to navigate through a set of liveable and probably improving oases and who then sets and alters his course based on the various landmarks and obstacles he encounters.

Ikonoclast, I’m having problems deconstructing your alternative political economy but are you suggesting the rich and powerful should rule by decree for it is sound very much like the dreaded fascist ideology.

Alice, I would be more than happy to lump you, JQ, Krugman and Stiglitz together.

You are right that extremism exists everywhere.

My concern is that ostensibly intelligent individuals who will argue for greater government involvement irrespective of whether or not the economic situation merits or requires government involvement. This is an ideological approach to economics that I am worried about.

I’ll give you an example. Robert Reich and Joseph Stiglitz believe that during the 1990s instead of moving into surplus the US government should have continued to spend hundreds of billions of dollars on infrastructure, social spending etc. Both would argue that their models (or Stiglitz’s models more precisely) would show that economic growth increased. However, if the US is facing a severe fiscal crisis now imagine what it would have been like if they did not go into surplus! Imagine how high the long-term interest rates would have been if they did no adopt a fiscal straightjacket and all the subsequent problems for the private sector.

In short, all too often we have people on the left and right who do not stop to argue for their pet causes. That is why when I read your opinions that there should be a larger permanent role for the government because the private sector is volatile and to provide “jobs”, I shudder. This is less economic than political. Conversely I shudder when I listen to the coalition try to get their heads around the need for a stimulus. Neither is pretty to watch.

@James
Attempts to link economics and the thermodynamics of gases are interesting but his doesn’t seem to be a promising area given that gas systems don’t have the instabilities that are a feature of economics. (Ex: Strong economic growth grows purchasing power which grows the economy etc.) There are times when the behavior of herds of sheep would seem to give better insights to what is going on in the economic world.

Perhaps it would be worthwhile looking at process engineering control as a model of what happens in the macro-economy as well as a source of solutions for managing unstable systems. For example, reactions involving exothermic reactions are unstable because the heat generated by the reaction drives up temperature which drives up the reaction rate etc. In many cases this instability will lead to disastrous overheating. In some cases, the temperature may be controlled by controlling the flow of cooling water into the cooling coils of a reactor. The control system must prevent the reactor reaching a critical temperature that is too high for the cooling system to control. Well designed and tuned control systems allows production to be maximized by bringing the “safe operating temperature” closer to the critical temperature. Competent process engineers will also consider changes to the hardware and process that might increase production, allow higher temperatures to be used etc.

This reactor case is analogous to the problem of avoiding overheating of the economy. Some of the strategies used to improve control and deal with problems such as changes in cooling water pressure, lag between valve movement and effect etc. might be applied to the economy problem.(All I can say is that the process company would go broke if Glen Stevens had control of the temperature set point.)

There are other process control problems that might be useful models for some of the things that happen in the macro economy.

@Michael of Summer Hill
Micheal, I am saying the exact opposite of what you say you perceive me as saying. I am saying the rich and powerful should not rule by decree. I am saying that letting society be guided by neoclassical economics allows the rich and powerful free rein and that this is a bad thing. It’s demonstrably a bad thing for everyone else and for the environment.

However, I must admit, I never know whether your posts are ironical or not.

I agree that the stimulus packages were necessary and the best we could do realistically as a short term expedient against the crisis. However, I also agree with Steve Keen that in the long run these packages are doomed to be inadequate and we will fall back into recession/depression. The reasons relate to the inablity of our current economy to maintain (almost) full employment and activity without the continuous stimulus provided by accumulating private debt for four or so decades. A debt level triple what it was before the great depression.

We have reached the end game of thisprocess, where debt must be paid off or defaulted on. Either way, a deleveraging must occur and it will be so severe it will cause a depression. The explanation of how to avoid getting into this situation in the first place is too lengthy to post here and now but they does involve, among other things, getting rid of the dead economic ideas of neoclassical economics.

Ikonoclast, be more optimistic for Australia is not going to the wall and it surely isn’t the end of the world. For once the global economy is in full swing Australia’s domestic economy will grow and public debt will dwindle as government receipts increase. As for private debt that is a different kettle of fish.

“Attempts to link economics and the thermodynamics of gases are interesting but his [sic] doesn’t seem to be a promising area given that gas systems don’t have the instabilities that are a feature of economics”.

Oh, yes, they do have such instabilities. The equations governing real gasses have zones in which the slopes of the curves reverse – and when that happens you get an instability that shows up as a phase change. This behaviour can be analysed with catastrophe theory, and there are indeed parallels with economics. I gave a short description of the phase change mechanism in gasses in passing, here.

Thanks PM, I suspected the same myself but I did not have enough specialist knowledge to state it for a fact. In addition, my analogy (relating the need for establishing STP conditons in measuring gas-liquid phenomena) was not intended to literally imply similar modelling for economics but simply to imply the need to eatablish standard ambient condition modelling for economics; ambient conditions being determined by the physical environment and the cultural-political-administrative-regulative environment (an ugly compound word, I know). This is the “condition box” I referred to and which maybe I should called pre-conditions, bounding conditions or even parameters.

Then there is the triple point of water, for example, where three phases of water can coexist, if the appropriate conditions are maintained. To continue the thermodynamics analogy with economics, perhaps it is better to view thermodynamics as an analogue for macro-economics, and the kinetic theory of gases as the micro-economic analogue.

Thermodynamics has a sound basis in the notion of thermodynamic equilibrium, which may be characterised by a few measurable variables (Temperature T, Pressure P, and Volume V) and an equation of state.

Statistical Mechanics allows one to drill down into the micro level of individual material particles, and to derive the principles of Thermodynamics by a process of statistical aggregation.

If the system in question is not in thermodynamic equilibrium then Thermodynamics runs into trouble; however, with some probably unjustifiable effort for the reward expected, the theory/theories of non-equilibrium thermodynamics could provide an exemplar for macro level economics. I can’t be bothered though.

Personally, I think models like those of Steve Keen are one effective way of establishing systemic failure conditions; just measuring a set of economic variables and statistically fitting a model won’t (can’t) yield such failure conditions, whereas “material” models that capture the flows of capital and the like at least have a fighting chance.

BTW, the 30-day limit on US mortgage repayments is at an all time high of 7.6% of mortgages exceeding the limit in August. Interesting.

@SeanG
Sean G,
perhaps then you would like to explain the case of Iceland where its banking sector grew three times as large as its GDP and the country is now bankrupt with 35 separate banking fraud cases so far.
You can rail all you like about the people you want to lump together (and let me say it here…being lumped with JQ and Stiglitiz and Krugman is far far better than JQ being romantically linked with Angelina Jolie…could only happen in a good blog!)

Shudder long into the night Sean G and yes we do need a bigger government if it means the entire legislation over the financial systems and corporate excesses has to be rewritten from the ground up, so that bankers be reigned in without further catastrope.

@SeanG
And Sean G – imagine where the US would be now if they had taken Stiglitz’z advice in the early 1990s to build infrastructure and improve health systems and perhaps education. Unemployment would be lower and they could have done that instead of wasting billions on two wars (Bush 1 and Bush 2).

Dont talk to me about wasting money in deficits when the US continue to waste in on military miuscle flexing and turning arms into the worlds greatest value export (sickening)…if they had taken Stiglitz advice they would have been far better off as a nation now than paying back the deficits run up by Dubya in a pointless war to enrich his corporate mates hands swilling down cocktails and tugging on his coat tails for a cut of US taxpayers taxes..and running Wall street into the largest collapse in our life time..

@ABOM
ABOM – I cant go to Sydney uni economics dept. Ive been answering exam stress questions all day about fiscal and monetary policy – in particular two about “Physical policy”. I told them they could learn all about physical policy at the institute of sport or ask Senator Fielding what it is.

One, I am not advocating some sort of laissez-faire approach to economic management. I believe that there must be government involvement in capital and human infrastructure development. Don’t think because I attack left-wingers such as Stiglitz that I am advocating the other extreme.

Deficit spending in the 1990s would have increased long-term interest rates. This would have had a negative impact on private sector growth which is the key determinant in additional government revenues via tax receipts and lower unemployment. If I may remind you Alice, it was the private sector in the 1990s in the US who laid down huge amounts of broadband and other telecommunications wiring. It is doubtful whether this could have been financed had the US government crowded out the private sector.

Crowding out – an issue that even JM Keynes understood.

Bigger government does not mean better government. Regulation will not improve the efficiency and effectiveness of credit flows.

Finally, Alice you must understand that try to paint me as some sort of war-loving, Bush-loving individual will not work. Dubya was incompetent. The deficits he ran up were due to huge cuts in taxes, huge increases in social spending and ttwo wars (one of which, Iraq, is not classified as anything other than a mistake).

@P.M.Lawrence
You are quite right. Dramatic changes can occur when supercooled or superheated water starts a phase change. However, when nucleation not a problem the the change is a case of stable equilibrium. For example the melting of ice removes heat from the liquid which slows down the ice formation. There are other interesting examples of instabilities associated with phase changes. For example, boiling actually starts to slow down once heating element reaches a certain temperature because the steam cannot get away from the surface and acts as an insulator – but this is not thermodynamics.

On the other hand exothermic reactions are unstable by their very nature and considerable effort has been put into control systems designed to avoid disasters and optimizing performance. They are certainly a lot more sophisticated than playing with interest rates. Perhaps economists may learn something by looking at how other professions deal with or step around control problems.

Also Sean you assume ceteris paribus where you’re not entitled. Yoiu can’t simply say “Imagine if they hadn’t had a surplus when they went into deficit” because the non-surplus would have been its own constraint. It also very much depends on what you spend the surplus on.

It’s also a mistake to treat surpluses as if they are simply like money in the bank held by individuals for a “rainy day”. They aren’t. Disbursing them and holding them have consequences on the macro context that individuals changing their cash balances don’t have. Modest individual debt and large scale corporate and institutional debt are also different things as recent events have shown.

@SeanG
Sean – it was the private sector who rolled out cable in Australia Sean but that was heavily subsidised by Government and we know who made lots of money on that and it wasnt government.

The entire crowding out argument is a crock as well. What does it matter if crowding out is 3%, 5%, 8% if GDP rises as is the purpose of a fiscal expansion. The problem with Monetary expansions is they are more helpful to borrowers and less helpful to savers, but no one talks about any disincentive to savings caused by eg a monetary expansion even though “lack of savings” is commonly cited as a reason for the yawning trade deficits. Cant have it both ways Sean.

Look – the whole point is exactly to be partisan. We have two separate types of policies here. Why on earth bludgeon fiscal policy and swear blind by monetary policy? The day that economic policy can get its head around the fact that these policies have different uses, different styles, and can be used effectively for different purposes – we are half way there. Im tired of the ideology war over which is better or superior. I couldnt give a damn really, but I am sick to death of people whinging that using fiscal policy will give us a bigger government. It might also give us a bigger more effective train service and clear the congested roads on my drive to work.

Im a firm believer there are some genuine services and structures in our economies, that in order to function effectively, the private sector should be disallowed participation.

You may not like it Sean but Im all for crowding out some of the private sector if it means the job of infrastructure and planning gets done better through public investment. I might actually suffer less real “crowding” and that would suit me fine.

Im strongly averse to the idea of hiving off great swathes of the public sector to private operators funded by banks (as we have been dong – we will pay for this one day…just as Iceland is doing now…mark my words!), and more people would be hired by the government (and those people will come with their own form of crowding in by any other name – you have heard of endogenous increases in GDP and the multiplier havent you Sean (I had to throw that at you seeing as you asked me about crowding out).

Our current fad of leaving it all to private markets is making one unholy mess, not only here. I dont mind the private sector and I like to see it vibrant but I dont want private interests running governments for their own self interest and that is what has been happening. The government risks total loss of control and perhaps it is half private already Sean which should give you less reason to complain – just dont expect Coalsville to care too much about the Australian people.

“You are quite right. Dramatic changes can occur when supercooled or superheated water starts a phase change. However, when nucleation not a problem the the change is a case of stable equilibrium.”

No. I was not referring simply to unusual cases like supersaturation when the outcome is abrupt and highly visible, but to the usual case. It is not dramatic, certainly, but a phase change with vapour above liquid (or below, if you have liquid ammonia evaporating into high pressure nitrogen) with one transforming into the other does involves – is the outcome of – instabilities. You don’t ordinarily see them unless supersaturation happens (although Einstein accurately predicted a special case where you can), but they are there; at a microscopic level, in the phase change zone, adjacent volumes are continually reaching disequilibrium and coming to a new equilibrium with one volume at one new equilibrium and the other at another. Away from the phase change zone adjacent volumes tend to align, not push apart (so to speak).

Interesting points. However, building up deficits during the 1990s would have – it is generally agreed in retrospect – kept long-term interest rates up. Unlike today where China, and the Mid East have huge capital reserves, back then the picture was entirely different.

Government in Australia has the critical mass. I do not dispute that although I wrote about what happened in the US, Alice. Please read my comments, don’t read into them.

Fiscal and monetary expansion creates growth. I do not doubt that. Fiscal and monetary expansion can create inflation. Both hurt savers. Why do you assume that I do not care about savers or am a monetarist? Why can’t you stop reading into my comments that I am some sort of Friedmanite?

Bigger government assumes that government is not effective in rail or road transport because it does not consume enough taxes or spend enough of taxpayers money. A wrong assumption if I have ever heard of it. A more effective government utilises taxpayers money efficiently and effectively. The problem is the blind assumption that any government expenditure is effective and for the best of intentions.

Unless the government is all-knowledgeable, with the best judgement in the world, the effects of policies will create negative externalities. Does this mean that I do not want public transport? Of course not. For some reason you always read your own bias into my comments.

I want effective government, one that invests my taxpayer money into effective, long-term payoffs. This means transport systems that work rather than having press releases about a new railroad that will never be built. I want good schools but recognise that the means to get there are inherently different. You see money spent – I see reform and money.

Crowding out of the private sector is not the answer. The law of unintended consequences is something you ignore. Higher interest rates erode private sector investment. Why bother investing in a productive piece of machinery when I can get a perfectly good return on a government bond?

Finally, I believe that “control” is a dangerous word. Progressive politics for the last three centuries has been about how to ensure that individuals and communities can control their own destinies, not the State. I think you should consider that point.

SeanG, one of the reasons you are enjoying such a good lifestyle in Australia is because individuals have taken collective action. We owe our democratic way of life to the likes of trade unions and others who were willing to take on the establishment. It is the State which now gives you your freedom.

A more effective government utilises taxpayers money efficiently and effectively. The problem is the blind assumption that any government expenditure is effective and for the best of intentions.

I have no such blind assumption…the best and funniest news I heard all week was Rudds episode of swearing when he wanted ton cut printing allowances of MPs. Good. Should be done more often…get rid of the much abused perks of public office.

However just as you claim there are people who have blind faith that any government spending is good spending (where are those people Sean?), I would claim there has been way too much emphasis on the efficiency and effectiveness of government to such an extreme (and it is a moving target) – who decides efficiency??? – one manager has his targets – the targets are raised for the next manager until he finds the real target for efficiency is to privatise his own department – or the manager above decides that solution would meet his targets – and then we wail because the privatisation turned out to be not such an efficient decision as everyone thought it would be and we would have been better NOT privatising that service.

Efficiency is a meaningless word – you can be too efficient Sean, wasteful and silly decisions have been made in the public sector in this country in name of efficiency. Its a term for all seasons and all reasons hence can be easily abused. Efficiency is a word like competitive – they can both be adapted to any situation eg its more competitive to reward CEOS obscene amounts and its more competitive to pay workers as little as possible. Well efficiency is the same. It is a term backed with no real measures and full of subjective interpretaion. A library or community hall or public park may be operating efficiently in terms of its staff and services and usage, but because they dont generate much profit if any – some would call that inefficient. Should be do away with the library because its not profitable, competitive or efficient? Or should we introduce user pays on parks, libraries etc so that only some can use them in the name of efficiency. Absolutely not.

I have an example of extreme inefficiency I would like to tell you about. I heard yesterday of a man who earns in the hundreds of thousands per annum who has so arranged his tax affairs, that he was able to claim the full $900 cash back after the GFC, which he has framed and now laughs about.

Tell me Sean – are there inefficiencies in the ATO, in this case, that can be rectified by further de-regulation or staff reductions in the name of efficiency gains within the ATO, so that this sort of obscenity and abuse by wealthy private citizens can continue?? Or do they simply need more resources (yes, bigger government) to be efficient??

@John Davidson , also PM Lawrence
The distinction between thermodynamics and statistical mechanics is a good analogy to apply here. At a statistical mechanical level, for any molecule or group of them (individuals, firms, sectors) things can change quite radically, producing (economic) “turbulence” and “chaos”; but changes in the macro variables (GDP etc) are much rarer. A strong finding in favour of using the thermodynamic analogy is that by Yakovenko and his research team that the distribution of money in the economy follows a Gibbs distribution, that is, the same as the distribution of energy among the particles of an ideal gas.
I’m sympathetic to the control theory system idea but it hasn’t yet been backed by a research program in the way that the econophysical paradigm has. There is some interesting work from econophysics suggesting that the pace of trades should be slowed so as to restore equilibrium conditions to e.g. one trade a day, preventing overdamping of the system and the resulting fluctuations.
To get back to JQ’s theme, the relationship between thermodynamics and statistical mechanics is pretty directly analogous to the relationship between macro and micro economics; but, even though it makes simplifying assumptions (assuming that molecules have no internal structure or degrees of freedom, for example) it seems to work much better than that between micro and macro. I think a key difference is that stat.mech. sums and averages over the whole range of possible outcomes at the micro level to get thermodynamics, whereas microeconomics seems to assume only one outcome (rational, neoclassical) is possible at the individual level and then gets in trouble trying to explain why the result of one rational individual * the population size is not a constant.

@Michael of Summer Hill
“…one of the reasons you are enjoying such a good lifestyle in Australia is because individuals have taken collective action. We owe our democratic way of life to the likes of trade unions and others who were willing to take on the establishment. It is the State which now gives you your freedom.”

This would have to set a new record for one of the most idiotic things I’ve heard said on this blog. I always knew that Marxism was the godfather of Keynesianism, but this is too much…

Yep, forget about bourgeois terms like “worker productivity” and “capital accumulation”, it was all the unions! All we need to do is open our wallets and spend, spend, SPEND our way to prosperity! Never you mind about the actual production of goods! Hail the State, in all its glory!

@Alice
You’re right to say efficiency isn’t everything. You are, attributing an attitude to supporters of the free market that they generally don’t hold. Just because they think government spending is generally wasteful (and my eonomics professor always said that he’s yet to come across a government project that passes a cost-benefit analysis) they wouldn’t say that the free market gets it right, because it doesn’t.

Again, this is the same problem with the strawman JQ sets up when he says free marketers believe the market always gets prices right. Of course it doesn’t, but who does he think will do a better job? The government? And how will they do so without introducing more distortions?

@Sebastian
Sebastian, does the quote “fire low and lay them out” mean anything to you?
If it doesn’t, I suggest you read a bit more about the history of australian democracy before asserting that the unions had nothing to do with freedom and a democratic way of life.
And btw, your conflation of ‘freedom’ and ‘democracy’ with ‘capital accumulation’ and ‘production of goods’ suggests that you are bringing an awful lot of ideological baggage to the table; most people are able to separate the concepts while acknowledging that political and economic systems are linked.
On prices and their determination, could I suggest broadening your mind by putting down the Hayek for a bit and reading some Sraffa instead.

@James
One of my key concerns at the moment is the mantra that say “we must put a price on carbon” if we want to drive down emissions. However, when you think about specific sources of emission such as power generation and transport emissions there are far more effective ways of reducing these emissions that avoid the need for increasing the price of fuels and/or driving up the average price of electricity to the point where investment in clean electricity is justified.

It may be a bit unfair but I have this vision of economists latching on to the standard idea of using artificial price rises to drive change and then sitting back with their arms folded telling us that we should accept their answer without question. One of the things that really stands out with climate change is that there is an enormous amount of R&D going on in the fields of climate science and clean alternatives but very little in the field of driving climate action.

Which is all a long winded way of saying that I am all for economists looking at thermodynamic analogues but get a bit nervous when you say:

I’m sympathetic to the control theory system idea but it hasn’t yet been backed by a research program in the way that the econophysical paradigm has.

It makes sense to me for economists to look at the way various professions have dealt with control problems including the control of process plants, power engineers dealing with the stabilization of power grids etc. Slowing the the pace of trades to restore equilibrium is almost a direct take from the basic control process control theory I did in the sixties. However, an understanding of the use of control cascades, weighting for the rate of change may give a a better way of optimizing the economy.

Thanks again James, for reminding us of Sraffa (who gets no mention whatsoever in any curriculum textbook, even though Samuelson himself regarded the man as the most important economist of his time along with Liontief).

I hope that Prof Quiggin’s discussion of the ‘macro wars’ in his book refers to the earlier ‘macro wars’ of the Cambridge Capital controversy. Should macroeconomics finally abandon the idea that prices are determined by marginal productivity? the links you posted earlier all emphasized that there are many more degrees of freedom that must be incorporated into economic models to make them reflective of the complex systems that they actually are.

Efficiency and effectiveness means have a TQM view towards services. You cannot deny there is vast waste in the public services! Are you denying, for instance, that there has been a massive overspend on construction for schools? Are you denying that government cannot be wasteful?

A bigger government is not a more effective government. Once you accept that central premise then this conversation can flow quicker towards areas that the government should be involved in rather than on a false debate that you seem fixated about.

The State does not grant freedom, Michael. That is a very disconcerting statement from you.

Our political-history stretches back to Locke and Hume. We are part of a country that has enormous political freedoms because individuals fought for it. The State has to be forced to give people freedom. Look at the Great Reform bill which had to be fought passed the vested interests who governed the British empire. It was the threat of violence and rebellion that opened up opportunities for trades unions to exist which helped further workplace standards. Do not think that the State grants freedom. It is a contradiction in terms because if the State grants freedom then it has the power to restrict it. Freedom is a natural law and not subject to the whims of politicians.

Iraq is a good example of the State vs no State. After the invasion, which was done with too few troops to maintain control and then dissolved existing state structures which may have compensated for the lack of troops, the anarchy that followed ended up providing far less ‘freedom’ than the tyrant. The laissez faire utopia is a fiction. It is a very bad state that is worse than anarchy.

JQ, it might be worthwhile providing a table of contents, with, maybe, a short explanation of what each chapter is about in the next bookblogging. That could give people a chance to suggest pithy chapter titles in line with the book’s ‘Zombie Economics’ theme. Reading the table of contents is part of things when looking at a book and making the purchase decision. Suitable chapter headings, like the title, should pique reader interest. I was also thinking that if something suitably snappy isn’t found to follow ‘Zombie Economics’ in the title, maybe just ‘Zombie Economics’ would be best.

@SeanG
Listen Sean – you didnt like supposedly lumping you in the basket og Friedmanites (which I did notdo) – I object to your incorrect assumption that I think any government involvement and government spending is good.

Sean – ridiculous. Im not pro 100% State ownership but Im also against 100% private ownership of the means of production.

Im, what I consider, a balanced person Sean. It depends on who does the job better and some jobs of production the govt does better and some jobs the private sector does better BUT NEITHER do the whole job of production. Its nice, when the comibination is right.

Im not idfeologically opposed to State production and Im not ideologically opposed to private sector production. I am ideologically opposed to people to who are ideologically opposed to one or the other of these two options.

I cant make it clearer. Call it centrist if you want. Call it socialist if you want. I dont care what you call it but I dont understand what your problem is.

@SeanG
Sean – you want to get personal? Crowding argument on fiscal policy is an utter crock (a monumental crock devised by the conservative ideologically pro private sector – did Keynes write about it? I doubt it. Even if he did – its been picked up, waved about like a victory flag ever since….oh woops we cant have that…ficsla policy may prevent some marginal in the private sector borrowing money

BIG deal Sean – its a total red herring – for every poor marginal who cant borrow in the private sector there will be people employed in the government (probably ten times more). Givernment pays people and firms when it spends. So waht you really mean is someone gets crowded out in the private sector and an equal number of private sector citizens get crowded in by extra employment or extra contracts from government.

Get over it Sean. There is NO SUCH THING AS CROWDING OUT.

Ive been telling my students to ignore this piece of rubbish for years.

Merkel can try to impose a cap if she wants. The cap proposed by France and Germany will not pass and if it does then bankers salaries will increase and the bonuses enjoyed will decrease. If they impose it on the EU, then London will suffer more than Paris and Frankfurt because the cap will be just high enough to hit the London-based banks. I guess Zurich will get a shed-load of more firms flooding there if it is an EU cap.

Even my Keynesian economics professors admitted that there is crowding out, the question is the extent. You claim it does not happen, that is wrong.

In 1993 the newly elected President US President spoke about his desire to drastically slash the federal budget deficit. Immediately long-term bond yields fell.

In the US, long-term bond yields have traditionally been the primary determinant of mortgage rates and loans to SMEs. By falling it meant that the positive effect of lower rates was passed onto the mortgage holder and the small businessman. This positive effect came from a speech. When the reality happened the US saw lower long-term interest rates and a pick up in private sector investment.

When you have a pool of investors and the government increases the size of the bond auction then over a period of time the interest rates increase in order to increase demand in these auctions. Gov’t bonds are essentially riskless and therefore with risk premium for corporate bond auctions pushes up corporate bond yields. Higher interest payments result in smaller profits and a restriction of investment opportunities to only those investments that can return a certain percentage to make it viable.

You think that the issue is purely a question of demand management. This is the problem with people who are essentially academic about the impact of governments involving themselves in the capital markets. It actually spreads around.

You state that the government involvement will employ more people, that it pays people and firms when it spends – you admit that it distorts natural market practice. Yet you do not look at the other side of the ledger. Where does it get this money from? Taxes and borrowing. If you borrow money from outside investors then it can push up inflation, increasing the short-term interest rates with pushes up short-term yields on bonds. Higher interest rates, higher inflation erode the spending power of savers and higher interest rates damage the P&L of companies. Do you deny this?

You like to talk about government action, but you do not understand how business is affected.

SeanG, you disappoint me for I thought you had a grasp on things. Maybe the EU is not legislating, but the UK has passed rules in August that state bank bonuses will no longer be guaranteed for more than a year, and that senior employees must have their bonuses spread over at least three years, and the French and German governments are outdoing each other in devising proposals to cap bankers pay. In August, the heads of the biggest French banks met with Sarkozy and agreed to new rules covering bonuses. Similarly, in the Netherlands banks are forgoing bonuses this year and prevented boards at banks from paying themselves more than what the staff were getting. Futhermore, the Netherlands Bankers’ Association this month passed a provisional banking code, which will take effect in January, that limited bonuses to no more than 100% of a banker’s annual salary.